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Subprime Crisis: Is There a Way Out?

The recent turmoil in the sub-prime mortgage market reverberated beyond the immediacy of that collapsed market, creating difficulties for borrowers, lenders and securitizers of both sub-prime and prime mortgages. Borrowers, the media and Congress are asking: What can be done? Unfortunately, that's a question that does not yet have an answer.

Economic research indicates that the 2007 crisis was brewing for six consecutive years before it actually occurred.[1] Between 2001 and 2007, the quality of sub-prime securitized mortgages deteriorated, and the susceptibility of the sub-prime mortgage market to economic shocks grew. A housing market slowdown—-a big economic shock—stopped masking the true risky nature of sub-prime loans and triggered the crisis. Moreover, the crisis was not driven by rate resets and was not confined only to adjustable-rate mortgages (ARMs). Fixed-rate mortgages contributed to the crisis, as well.

With the sub-prime mortgage market disappearing, another ominous word has started taking the place of sub-prime in the popular media: foreclosure. The Eighth District, like the rest of the nation, is facing a massive wave of sub-prime mortgage delinquencies and foreclosures. In Illinois, for example, almost 60,000 households entered foreclosure between Sept. 30, 2006, and Sept. 30, 2007. In Missouri, about 27,000 foreclosures were initiated during the same time period.

Foreclosures have devastating personal consequences, but they are necessary. Without foreclosures-or more precisely, without the threat of foreclosures-it would be impossible to enforce timely monthly mortgage payments. Also, without foreclosure as an option, the mortgage interest rate would be much higher. Borrowers would know that there is no punishment for not making payments. Lenders would see this situation as an elevated risk of mortgage lending and, to be compensated, would raise the mortgage interest rate.

Finding Solutions

Foreclosures are costly. However, renegotiations of mortgage contracts are also costly. Securitization makes renegotiations between a lender (or a servicer) and a borrower almost impossible. The Bush administration has taken steps to ease renegotiations by proposing the American Securitization Forum (ASF) framework to freeze mortgage rates for five years for a number of borrowers with sub-prime securitized 2/28 and 3/27 hybrid ARMs.[2] The ASF projects that approximately 1.2 million borrowers would qualify for the fast track loan modifications, but some private forecasters expect as few as one-fifth of that number to benefit.

The government's plan, however, doesn't quite get to the heart of the matter. Among securitized sub-prime ARMs originated in 2005 and 2006, almost 20 percent were already seriously delinquent (past due more than 60 days) just one year after origination—one to two years before the resets would have occurred. These loans will not qualify for the ASF modifications because they are already seriously delinquent. Most importantly, modifications will not solve the problems because they were not caused by resetting rates.

The government's plan helps illustrate how the depth of the current crisis is yet to be realized. Still, policymakers are analyzing and searching for an ultimate solution to the persisting sub-prime mess.

To ease the problems with outstanding sub-prime loans, a dramatic restructuring of the sub-prime mortgage market-especially the securitized portion-is needed. As an example of a sizable intervention, the federal government may need to provide a new type of loan guarantee-similar to an FHA-type, but applicable to sub-prime loans. This would let borrowers with sub-prime loans (re)build equity in their homes. As a more radical proposal, a program similar to the one run by the Home Owners' Loan Corp. (HOLC) during the Great Depression may help stabilize the market. The HOLC refinanced about 1 million mortgages that were in default. The program did not require public financing other than its initial capitalization. Such a stabilization program-one that would first wipe out sub-prime debt and then recapitalize existing loans-would most likely be more expensive today than in the 1930s and 1940s because we are in very different economic circumstances.

These potential solutions would take time to work and are costly. In the meantime, modifications on a loan-by-loan basis, timely information to borrowers and mortgage counseling may help many borrowers postpone or avoid foreclosure. If lenders choose to write off some debt, it is critical that money continues to move-in other words, lenders need to keep issuing new loans to be able to absorb any current recapitalization in the future.

The bottom line is that the mortgage market must not freeze up. To prevent the occurrence of such a crisis in the future, more financial education for existing and new borrowers is needed.